SRC Insights: Third Quarter 2009

Fair Value Measurement: Challenging, yet Attainable

by William Lenney, Regulatory Applications Specialist, and Paul Matteo, Intern

In today's market, some financial institutions have reported significant amounts of unrealized losses on their available-for-sale and held-to-maturity securities portfolios. Financial institutions and external auditors have been challenged in determining when a decline in the fair value of a security is an other-than-temporary impairment (OTTI), and, therefore, would need to be reported as a loss on the income statement.

Since FAS 157 was released in 2006, there have been challenges with fair value measurement when markets are inactive or transactions cease to be orderly.1 The Financial Accounting Standards Board (FASB) issued guidance on April 9, 2009, to clarify fair value measurements and to change the accounting treatment for other-than-temporary impairment for debt securities.

FASB Staff Position (FSP) FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, provides guidance for fair value measurements when markets are not active. FSP FAS 115-2 and FSP FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments, change the method for determining OTTI for debt securities and recording the impairment in the financial statements.

Although some transactions may not have appeared orderly during the past year, FASB asserts that measurement has only become more difficult, not that order has ceased to exist. Fair value can still be measured, but entities might have to search diligently for accurate values in markets that are not as active. To improve fair value measurements, FASB created a list of market and transaction conditions that may indicate the presence of Level 3 inputs.2

FSP FAS 157-4 provides specific factors to consider when determining whether a market has become inactive:

Few recent transactions.

Price quotations not based on current information.

Substantial variation in price quotations over time or among market makers.

Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability.

Significant increase in implied liquidity risk premiums, yields, or performance indicators for observed transactions or quoted prices when compared with the reporting entity's estimate of expected cash flows, considering all available market data about credit and other nonperformance risk for the asset or liability.

Wide bid-ask spread.

Significant decline or absence of a market for new issuances for the asset or liability or similar assets or liabilities.

Limited public information available.

After considering these factors, a decision should be made regarding whether market activity has decreased significantly, and whether the market quotations represent fair value. Adjustments may then be necessary to achieve fair value through the use of valuation techniques, e.g., market approach, income approach, or cost approach. FASB, however, does not indicate that any individual technique is superior to another. The technique that would make use of the best available inputs should be used.

Emphasis for determining fair value measurements should be on making use of the best inputs available, not on using the best technique. If the market is not active, then the inputs used will most likely be Level 3 (Fig. 1). When a market is less active and several transactions may not be orderly, Level 2 or 3 inputs will most likely be found.

FASB has also created indicators that, when observed in a transaction, could demonstrate a potential lack of orderliness in that transaction. These factors are:

Inadequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions.

A usual and customary marketing period exists, but the seller marketed the asset or liability to a single market participant.

The seller is in or near bankruptcy or receivership (i.e., distressed), or the seller was required to sell to meet regulatory or legal requirements (i.e., forced).

Transaction price is an outlier when compared with other recent transactions for the same or similar asset or liability.

If the transaction is no longer deemed orderly, then the transaction price is not considered indicative of fair value. However, if the situation is more complex, and the circumstantial evidence deems the transaction orderly despite the presence of those factors listed above, then weight can be put on the price as demonstrative of fair value.

If little information is available to indicate that the transaction is either orderly or not orderly, then this transaction price is not considered to adequately represent fair value. Given limited options of other inputs, though, this information can be used to make a determination of fair value, but good judgment should be used in making that determination.

If the market is active and orderly, then the inputs used will typically be Level 1 (Fig. 1). If the market is active and some transactions are not orderly, Level 2 inputs will most likely be used. Occasionally, if the market is active, but not orderly, then Level 3 inputs should be used.

FAS 157-4 requires disclosure of the inputs and valuation techniques used to measure fair value during interim and annual periods. Securities should be segmented into major categories, such as equity securities, debt securities issued by foreign governments, corporate debt securities, etc., and this information should be disclosed in the financial statements.

FSP FAS 115-2 and FSP FAS 124-2 provide guidance on establishing improved consistency to the timing of impairment recognition and achieving better clarity about the credit and noncredit components of debt securities that are not expected to be sold.

Previously, unless management could definitely assert its intent and ability to hold a security until a forecasted recovery date, an OTTI write-down was necessary. FSP FAS 115-2 provides clearer guidance on how and when to write down a debt security. An assessment should be made regarding whether 1) there is intent to sell the debt security, or 2) it is more likely than not that a sale of the debt security will be required prior to its anticipated recovery. If either of these conditions is met, an OTTI must be recognized.

If a security is impaired and there is intent to sell, then an OTTI write-down is necessary (Fig. 2). An amount equal to the entire difference between the investment's amortized cost basis and its fair value on the balance sheet date should be reported on the income statement. However, even if there is no intent to sell, and a sale is not required, an OTTI should still be recognized. The OTTI in this case will be separated into either the amount representing credit loss or the amount related to all other factors.

Impairment related to credit loss should be recognized in earnings, while impairment related to other factors should be recognized in other comprehensive income, net of applicable taxes. The OTTI related to the security's credit loss should be measured as the difference between the present value of the expected cash flows and the amortized cost basis.

The amendments to FASB statements 115 and 157 should make it easier to apply fair value measurement standards. However, sound judgment and good reasoning are still vital to the application of both statements. FASB aims to establish that fair value is still attainable, even during today's difficult economic situation. Nevertheless, financial institutions and individuals will need to be vigilant as they work harder to attain a reasonable measure of fair value.

1 An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g., a forced liquidation or distress sale).